Nasdaq faces threats to its competitive advantage

Dollars & Sense

October 06, 2002|By Rachel Barnard | Rachel Barnard,MORNINGSTAR.COM

You may already own some Nasdaq stocks. Companies such as Microsoft, Amazon.com and Cisco Systems. You may even own shares of Qubes (the Nasdaq 100 index). But what about owning shares of the Nasdaq stock market itself?

Buying into an operation such as Nasdaq may sound confusing, rather like buying a stake in the department of motor vehicles rather than simply investing in a car. The DMV doesn't make or sell cars, but you can't drive on the roads without paying it a visit and ponying up fees for a driver's license and plates for your car. That gives it a type of monopoly, permitting it to thrive without competition.

While state governments aren't likely to sell off their motor vehicle offices anytime soon, investors may get the chance to own shares of the Nasdaq market if the company goes forward with its plans for an initial public offering. As an investor, you may already be asking the relevant questions about the Nasdaq: How does it make money? Does it have a competitive advantage? Is it sustainable over the long term? We've asked ourselves the same questions about the business of running an exchange.

Most people have the same image of a stock exchange: frenzied traders running around, clustering in trading pits and flashing hand signals to other equally frenzied traders. Somehow amid the din and chaos, shares are bought and sold. This is what you see at the New York Stock Exchange or other exchanges with trading floors. The Nasdaq exchange, on the other hand, is just a bunch of computers sharing data and executing matches between buy and sell orders. It's not as exciting to watch, but it gets the job done quickly and efficiently.

When an investor makes a trade, the order is typically taken by a broker, who then has a choice of several electronic trading systems to which he or she can submit the order. These systems display the best buy and sell prices currently being offered in their systems. They match up buy and sell orders and execute a trade, which is then reported to Nasdaq and settled within a few days.

So far in this scenario, it isn't obvious that any money has flowed into Nasdaq's coffers. But the company has been making money every step of the way.

Nasdaq has three major buckets of products and services which account for 96 percent of its revenue. The first one consists of fees that the exchange charges to companies who want their shares listed on Nasdaq's exchange. This accounts for about one-fifth of revenue. Companies have to pay a fee for the initial listing, and then additional fees for listing more shares. They also have to cough up annual fees. So Nasdaq is earning revenue from every business that wants its shares to trade on Nasdaq -- currently more than 4,000 companies.

Nasdaq also makes money by selling data on stock prices throughout the trading day. As trades are executed, the firm collects the data and ships it off to data providers. Any Nasdaq stock quotes you see during the day -- on CNBC or Yahoo! or Morningstar -- are generating income for the Nasdaq stock market. The firm earned nearly one-third of its revenue from data sales last year.

Nasdaq has a near-monopoly on this, although competitive pressures are bubbling up from regional exchanges, which have found that they can sell their data, too. Some exchanges, such as the Cincinnati Stock Exchange (located in Chicago), have started giving kickbacks to electronic trading networks who post trades with them instead of Nasdaq.

The third and biggest chunk of Nasdaq's revenue, nearly 50 percent, comes from trading services. Nasdaq charges fees to access its network for the purpose of entering a buy or sell order and for matching these orders and trading the shares. Fees are charged either by the order or by the share, so Nasdaq makes more money when a greater volume of shares is traded through its system. The company also sells software products which allow customers to get quotes and make trades, all from their desktop computers.

It is in this area of trading services where Nasdaq faces its most heated competition.

The majority of Nasdaq trading is not done by Nasdaq. This sounds confusing, but the distinction is an important one. As a stock market, Nasdaq acts more like a newspaper which runs classified ads. A customer pays a fee to put his ad in the paper saying he wants to sell his 1985 Buick Skylark for $300. The newspaper collects the fee for the ad, but not the $300 or a commission. Nasdaq works the same way. Microsoft pays to list its shares on the exchange, but they can be traded in any number of ways.

Nasdaq's trading system is only one of many, and Electronic Communication Networks (ECNs) are its biggest competition. Firms such as Instinet and Archipelago have simpler, faster systems, and a recent price war has made ECN commissions very cheap. ECNs trade 45 percent of Nasdaq share volume while Nasdaq itself trades only 30 percent. The rest is done by brokerage firms in-house.

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